The Relationship Between High Return Correlations, Portfolio Risk Management and Market Issuance in Six Emerging Markets

Abstract

This paper examines the importance of market-wide high investment return correlations to risk averse investors and corporate claim issuers in emerging markets. We that high correlation between investment returns is associated with two limits to the value of these emerging markets to investors and issuers: 1) well-diversified portfolios cease to provide efficient risk reduction, and 2) the market ceases to support issuers with diverse return volatilities. We examine the implications of high intramarket return correlations in a sample of six emerging markets that differ widely in the degree to which investment returns are correlated on the average. We use a GARCH(1,1) estimating procedure to form dynamic estimates of the variance-covariance matrix of returns in each country separately over time. From these matrices, iterative methods are used to form direct estimates of the weights of sector investments in the minimum variance portfolio of domestic risky assets. We find that there are four phenomena associated with high correlations in emerging markets. First, well-diversified portfolios cease to be the minimum-risk collections of risky securities in the emerging markets examined during crisis periods. Indeed composite index growth variances average about twice the variance of a constructed minimum risk portfolio that is not well diversified during crisis periods. Second, the constructed minimum variance portfolio has investment weights that change substantially over time, necessitating the incursion of higher transaction costs to minimize risk. These costs increase during crisis periods. Third, for the two markets with the highest return correlations during normal periods (Mexico and Turkey) the composite portfolio is sometimes not the minimum risk portfolio in normal times. Minimum risk investors use hedging strategies to minimize risk, rather than diversification strategies in forming minimum risk portfolios in these two markets. Fourth, the ability of a market to sustain differing average stock market volatilities is strongly inversely related to the average correlation between stock market returns. Markets with high correlations between investments may be limited in the degree to which they can support the issuance of low risk investments at attractive costs of capital.